Bonds - what happened?
David Robertson, Head of Economic and Market Research at Bendigo and Adelaide Bank
February-March 2018
This month’s dramatic sell-off in US stocks, which caused similar falls around the world in percentage terms, has been blamed primarily on an unexpected jump in US wages growth, flowing through to higher bond yields.
So - what drove this event, and what are the likely consequences for the Australian economy?
The US jobs data released on Friday, 2 February 2018 revealed strong jobs growth and unemployment remaining at a 17 year low of 4.1%*. However unlike previous similar data, this time there was an acceleration in US wages growth.
The lack of wage pressures despite a tightening labour market had confounded analysts for some time, with economic theory citing the ‘Phillips Curve’ as the expected correlation between rising employment and rising wages growth/ inflation. This latest data was interpreted as a resumption of the normal correlation- so inflation picking up now, and likely to continue to do so with other stimulus such as imminent tax cuts.
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The benchmark 10 year bond rate rose in line with this data initially to 2.76% and a few days later to 2.93%, its highest level in four years. While these yields are historically still very low, the combination of this ‘new news’ with other factors such as reducing QE (so less demand for US bonds) appeared to break the camel’s back for US stocks - acknowledgment that 3 to 4 Fed rate hikes this year are ‘real’.
Rising interest rates always challenge stock markets via the discount rate on future earnings for current valuations and by offering a competing asset class, such as higher yielding bonds.
The reaction from US stocks though was a quantum leap from the well-entrenched bull market. Overall the decline from record index highs in late January to the low on February 9th was 11.8% for the S&P500, 11.7% for the Nasdaq and 12.2% for the Dow.
Historically there has been a good correlation between rising inflation (and interest rates) and periods of recession, although we are coming off a very low base in this case. As Figure 4 shows, US equity market falls often preempt the economic cycle, anticipating when interest rates are rising in an unsustainable manner: often this is evident when the yield curve begins to flatten. Periods of rising interest rates and inflation are matched by rising stock markets, but are punctuated by recessions.
Since the initial selloff some stability has returned to equity markets, both in the USA and in major bourses around the world.
The primary impact of higher US rates locally is likely to be seen in stocks (which are highly correlated to US equities) and FX markets. Our bond markets have weakened during this recent period of instability, with Australian 10 year bonds now slightly lower than the US equivalent**. The ASX200 fell 5.5% in February (from 6121 to 5787) and is now nearing the midpoint of this range**.
The last time our 10 year rate was below the US, the Aussie Dollar was trading around 55 cents**. The fact that we are now trading in a 75- 81 cent band has surprised many forecasters who had correctly expected higher US rates, but assumed incorrectly looked for a stronger US dollar. The fact that global growth is stronger (not just US growth) and a better outlook for the EU has strengthened the euro currency, and helped push commodity prices higher, which is supporting the Aussie dollar.
Local implications from the February US bond and stock market selloff can be summarised as:
- Three to four US Fed rate hikes are now expected in 2018, which should continue to push bond yields higher and accelerate the US economic cycle. Equity markets may experience higher volatility as a result, and volatility in other asset classes may rise but to a lesser extent.
- Currency markets are not observing a stronger US dollar despite rising US interest rates due to other factors including strong growth and higher rates around the world (not just the US) and also the weak US fiscal outlook.
- The RBA continues to suggest the next move in rates will be up, but the tightening cycle will not start here until there is a lift in wages growth (the primary factor that initiated this event in the US).
*US Bureau of Labor Statistics - www.bls.gov/news.release/pdf/empsit.pdf
**Thomson Reuters: www.thomsonreuters.com
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